The buyers: The Quams and the too-good-to-be-true mortgage

Stretched by their loan, the newlyweds rented out their second bedroom to pay the bills.

By Amanda Gengler, Money Magazine writer-reporter

(Money Magazine) -- Newlyweds Erik and Brandi Quam can't really afford their home. The monthly carrying costs on their two-bedroom condo in Arlington, Va. run about $2,500 a month, and they fear the bill could go higher still as their adjustable mortgage resets to higher interest rates. It's already a tight squeeze: They've taken in a roommate to help pay the bills.

Unfortunately, they can't afford to sell either. Thanks to a falling housing market and a prepayment penalty of about $11,500, they'd owe the bank more than their place is worth. "It makes me want to cry every month," says Brandi, 26. The irony is that the Quams should be able to afford their place: It cost just $219,000 when a still-single Brandi, fresh out of the Air Force, bought it.

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Brandi and Erik Quam
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So how did they get themselves in such a mess? More puzzling still, why did lenders let them - along with millions of other homeowners, many of whom, unlike the Quams, are in immediate danger of foreclosure?

In the answer to that question lies the real story behind the once dizzying, now fizzling housing boom. Sure, record-low interest rates, boomers buying vacation homes and immigrants grabbing for the American dream all did their bit to push up prices.

But what really supercharged the market was the mortgage industrial complex - a machine with cogs called brokers and bankers, fueled by money poured in by investment banks, bond traders and hedge fund managers. The system prospered and grew, introducing new players into the financing transaction and transforming the roles of others.

Finally it ran amok, creating huge incentives at every level of a home sale or a refi to sacrifice prudence in pursuit of a killing. Market checks and balances should have prevented the process from getting out of control. But they were corrupted, co-opted or simply steamrollered.

Too much money. Too little restraint. This is the story of how all the important players in the market decided that they had too much at stake to shout, "Stop!" We've been here before: Remember when Wall Street analysts told us Amazon.com was worth $400 a share?

And as with the tech bubble, it may not be only speculators who get hurt. As home prices unwind from unsustainable highs, we may all feel at least a little bit poorer. That could be a drag on the economy. It's already a real drag for the Quams.

The primary mortgage on the Quams' condo was fixed at 5.25 percent, but Brandi had also taken out a smaller variable-rate loan. As rates rose in 2005, she went looking for a better deal and entered her contact information into a few Web sites.

Shortly thereafter, she says, she got a call from broker Robert Hoover of CPA Mortgage in Maryland. He found her a new loan with what she says she understood to be an initial 1 percent rate, with only small increases in the first five years. And since she had equity (her condo had appreciated), she could even take a little cash out to pay off some bills. The transaction earned the broker and his firm about $12,600.

It took a few months before Brandi realized what she had done. The mortgage was something called an option ARM. It was true that Brandi could make initial minimum payments of about $800. But those weren't enough to cover the interest she was actually being charged, which was higher than the rate used to calculate required payments. The unpaid interest was added to the loan balance, a phenomenon called negative amortization.

The Quams have decided to start paying at least the interest on the loan, but even so, the balance has grown by $7,000. Barring a market turnaround, they're stuck for at least another year and a half until the prepayment penalty phases out. They've had to turn down job offers because they can't move.

Who is to blame here? Yes, Brandi should have asked more questions and scrutinized the fine print. The idea of a mortgage with a 1% rate seems, on its face, too good to be true. Brandi says she did know she'd eventually have to make higher payments, but she planned to move before that happened.

Exactly how Hoover described the mechanics of the loan, or what she thought he meant, is impossible to know for sure now. Hoover declined to speak with MONEY, and his firm sent an e-mail saying that it couldn't comment on a client but that "ultimately, it is the consumer that makes the choice they feel is best."

But based on the documents Brandi showed us for her loan - and documents MONEY has seen for other option ARMS - it is easy to see how a person could be confused.

A payment schedule is shown on the federally mandated truth-in-lending form, but it is based on minimum payments and a steady interest rate, rather than the variable rate the Quams are charged.

An "adjustable-rate note" first says the Quams will be charged a yearly rate of 1 percent. The next subsection says that rate "may" change almost immediately. The first payment coupons show only the minimum, negatively amortizing payment.

A spokeswoman for the original lender, BankUnited of Miami Lakes, Fla., said she couldn't specifically comment on Brandi's loan. But she said that borrowers aren't approved unless their "credit score will support the fully indexed rate." All borrowers, she added, acknowledge receipt of numerous documents disclosing every aspect of the loan, including a four-page form that describes the terms "in plain English" and warns borrowers of the possibility of negative amortization.

Keep in mind, complex loans like option ARMs are new to most people, and they are radically different from 15- and 30-year fixed-rate loans. Consumer advocates say that the truth-in-lending disclosure rules are outdated and that borrowers like the Quams are being asked to climb a steep learning curve - with their homes at stake.

"The disclosures on adjustable-rate mortgages have never been any good, and option ARMs are particularly terrible," says Jack Guttentag, professor emeritus of finance at the University of Pennsylvania's Wharton School.

In any case, the loans are popular. In the first half of 2006, option ARMs were 15 percent of mortgage originations, reports the Mortgage Bankers Association. In theory, the loan can be a useful tool for people with irregular income, such as entrepreneurs.

But low payments are the rule, not the exception. Today more than 80 percent of borrowers in securitized option ARMs pay less than their interest charges, according to Fitch Ratings. Their loan balances are rising. That might not be so bad in a rising market, but it's potentially a disaster in a falling one.

It's obvious that a lot of homeowners could have used better advice about how to find an affordable loan. But good advice has gotten harder to come by in the mortgage game. That's because the person across the desk or on the other end of the telephone getting you a mortgage probably doesn't work for the bank that's putting up the money. He may not care if you can pay.

"Consumers thought that when they qualified for a loan, that meant they had a reasonable prospect to repay the loan unless some type of illness or catastrophe hit the family," says Michael Calhoun, president of the Center for Responsible Lending. "That is no longer the case."

Next scene from a bubble: Would you get your mortgage from this man? Top of page



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Market indexes are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer Morningstar: © 2014 Morningstar, Inc. All Rights Reserved. Disclaimer The Dow Jones IndexesSM are proprietary to and distributed by Dow Jones & Company, Inc. and have been licensed for use. All content of the Dow Jones IndexesSM © 2014 is proprietary to Dow Jones & Company, Inc. Chicago Mercantile Association. The market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. FactSet Research Systems Inc. 2014. All rights reserved. Most stock quote data provided by BATS.